401(k) is an employer-sponsored retirement savings plan that allows employees to stockpile and invest a part of their pay check before the taxes are deducted. Taxes are paid only after the money is withdrawn from one’s account. 401(k) contributions can ease up your taxable income and help slash your tax bill. For instance, if you contribute $1,000 of your monthly income of $4,500 to your 401(k), only $3,500 of your pay check will be deducted and accounted for tax. The money that is there in your account is protected from taxes as it keeps growing.
The money can be invested in several bond funds, stock funds and target-date funds (which usually become more conservative with time). An average 401(k) plan offers close to 19 funds with nearly half of them invested in U.S. stock funds.
The 401(k) plan is one of the simplest and most effective ways to lay aside savings for your retirement. Although the plan has an advantage of letting you put a part of your pay into your account automatically, there are some limits on the amount you can contribute.
Additionally, many companies contribute to employees’ accounts up to a specific percentage of their incomes regardless of whether the workers contribute their own money. As per the Plan Sponsor Council of America, companies contributed an average of 5.1% of a worker’s pay to their 401(k) account.
What is the 401(k) Contribution Limit for 2020?
For the year 2020, workers can contribute a maximum amount of $19,500 to a 401(k) if they are below the age of 50. This amount is a $500 increase compared to 2019. Workers who are above the age of 50 can pool in an extra $6,500 annually in “catch-up” contributions, which sums up their 401(k) contributions to a total of $26,000 for 2020. Older employees get a higher cap on their contributions due to the less time they have left until retirement. 401(k) contributions are generally due at the end of each calendar year.
What is the Ideal Saving for Retirement in a 401(k)?
Numbers again, let’s take a look at some more statistics! At least 15% of workers’ income should be saved in for retirement which can include any employer match. Say, for example, if your employer contributes 4%, then you would need to pool in an additional 11%.
The best way to get to saving 15% is to increase the amount in a piecemeal fashion by 2% each year till you get to the 15% level. So, if you are saving 3% currently, step it up to 5% next year, 7% the following year and so forth.
A sizable cache reserve can be built up using the tax-deferred growth of a 401(k). For instance, an annual return of 6% on a contribution of $5,500 per year to a 401(k) for a 25-year-old will amass a nest egg of $902,262 at the age of sixty-five. However, if the same person is in the tax bracket of 22% and ends up saving the same amount assuming the same return in a taxable account, at the end of 40 years, the balance would add up to $643,500.
There are some rules to withdrawal of the money. You will not owe a 10% penalty if you are at least 59 and half years old when you withdraw money from your 401(k). Also, if you are aged 55 or beyond in the year you leave your employer, you are exempt from the early-withdrawal penalty.
You will be subjected to the ordinary income tax upon withdrawals. Additionally, you will be obligated to take required minimum distributions upon reaching age 70 and a half. However, there is an exception to that rule if you are still working at the age of 70 and a half. In addition to that, if you do not own more than 5% of the company you are working for, then you do not have to take required minimum distributions from the 401(k) that you got via that job.
Most often, employers provide a matching contribution which you should be taking advantage of; otherwise, you end up rejecting free money. However, it is also essential to understand how the matching contribution functions.
“Sometimes there’s a vesting requirement to get a match”. So you may not get it in reality if you are planning to leave anytime in the near future.
Although your contributions are always secured in the plan which implies that your account is immediately credited, some restrictions are thrust upon by employers sometimes to incentivize workers to stick around. There could be a three-year cliff vesting schedule so it is very much possible that you only find a match after hanging around for three years. “sometimes matching contributions are not subject to a vesting schedule – meaning that they are immediately vested.”
In most cases, up to 6 percent of an employee’s salary is offered as an employer match on a 401(k) plan which works out to be equal to 3 percent of compensation. For instance, an employer may add 50 cents or $1 for every dollar contributed by the worker. Employees would have to hold off 6 percent of their salary towards the 401(k) plan in order to take advantage of the complete match. The total employer and employee contributions limit for the year 2019 is $56,000 or cent percent of employee compensation, whichever option works out lower. On the other hand, the limit is $62,000 (which includes $56,000 plus the catch-up contribution of $6,500) for workers 50 and above.
While some plans may be more generous offering up to 6 percent or more as a total match, make sure that you make use of the employer’s match since that is free cash for you and also an assured return on your investment!
Saving Tips for Retirement by Maximizing your 401(k)
- You can strive to hit the $19,500 limit and maximize your contribution every year that you are able to.
- You can add another $6,500 to the aforementioned limit each year once you hit 50 and continue to work.
- Make sure that you invest at least as much as your employer offers to match your contributions in your 401(k) each month. After all, all that money is free!
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